Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
Ross and Rachel. Mulder and Scully. The UK Monetary Policy Committee and interest rate hikes. You know they’ll eventually get together, but you can also bet on plenty of twists and turns before they do.
This time it’s the Monetary Policy Committee (MPC) holding out. After yesterday’s policy meeting on Threadneedle Street, the committee decided interest rates should remain at their historical lows of 0.1% until it was clear how quickly the economy would recover.
The reason markets are so invested in this “will they, won’t they” story ultimately concerns inflation. Raising interest rates would be used to stem any rise in inflation. Deciding not to raise them shows the MPC continues to believe that any price rises now are strictly temporary.
Markets, on the other hand, are growing fearful the economic recovery is happening faster than expected, and that inflation could get out of hand if policymakers don’t act to contain it.
They may have a point. UK Consumer Price Inflation rose to 2.1% last week, higher than the 1.8% expected. Even the MPC has acknowledged that “developments in global GDP growth have been somewhat stronger than anticipated” and inflation is likely to rise further - it suggests it could exceed 3% - though reasserting that any rises would be strictly “temporary”. Some analysts forecast something closer to 4%.
The Bank finds itself stuck between a rock and a hard place. If policymakers do eventually decide they’re worried about inflation, they will have to be extremely tactful with any measures to curtail it. Go in too hard, and you risk panicking a market which is getting used to a hitherto “dovish” policy.
The risks were laid bare by reaction to the US Federal Reserve’s comments on inflation last week. Both the Fed and MPC stood by their assertions that inflation now would prove temporary, but there were some notable changes of stance in the US. Seven of the eighteen members of the Open Markets Committee said they expected a rate increase in 2022 compared with four previously. Thirteen said they expected at least one rate hike in 2023, versus just seven before. The average expectation is for two hikes next year to between 0.5% and 0.75%.
Ultimately, the news shouldn’t have come as a massive surprise. But markets couldn’t help but let out a gasp. Investors hurried from “reflationary” value-focused stocks to the sort of defensive growth companies that do better in a less buoyant environment. Commodities (a typical hedge against inflation) tumbled, while yields on long term bonds fell to the sound of a higher rate, lower inflationary future.
Things have begun to level out again since the Fed’s announcement last week, but the precedent for market tantrums has been set.
Conversely, there are risks in going too far the other way. No central banker has worked during a time when inflation was a problem - for that you have to go back to the 1970s. You don’t know inflation of that kind is here until it’s too late. The MPC cannot risk acting too slowly and getting stuck behind the curve.
Fortunately, there are good reasons to think inflation will prove temporary. It’s likely that growth here and in the US will peak this quarter and begin to level out over 2022. Imbalances between demand and supply should begin to level. Moreover, most of the price rises we’ve seen so far have been skewed towards the kind of products and services which were affected by the pandemic. High demand for those should prove transitory.
So, what does this mean for investors? More of the same, really. Assuming inflation does exceed 3% for a period, as the MPC now expects, interest on cash savings will be less than price inflation, meaning it will lose value in real, inflation-adjusted terms. That’s a bitter pill to swallow, but it’s still worth keeping some money in cash just in case (at least six months’ worth of everyday expenses is a good rule of thumb). My colleague, Tom Stevenson, wrote about this recently.
Ultimately, the best response the MPC’s announcement is the most boring one. No one, including the Bank of England’s sharpest economists, know exactly what’s going to happen here. Make sure you’re well exposed to both the reflation trade - value, cyclicals, commodities, etc - as well as those more defensive names so you’re covered for both eventualities. Being well diversified is your best option.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to a Fidelity adviser or an authorised financial adviser of your choice.
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